Banks Commercial Real Estate Lending and Risk Analysis

Banks play a crucial role in commercial real estate lending, providing financing for developers, property owners, and businesses. They assess the creditworthiness of borrowers and evaluate the risk of a loan.

Commercial real estate lending involves a thorough analysis of the property's value, income potential, and market conditions. This analysis helps banks determine the loan-to-value ratio and interest rate for the loan.

Banks consider various factors when evaluating a loan application, including the borrower's credit history, financial statements, and business plan. A strong credit history and solid business plan can increase the chances of loan approval.

Commercial real estate lending is a complex process, requiring a deep understanding of the property market and the borrower's financial situation.

Credit and risk management are crucial aspects of commercial real estate lending. A bank's lending policies should communicate the level of risk acceptable to its board of directors and provide clear and measurable underwriting standards.

Institutions should consider several factors when managing construction loans, including independent property inspections, loan disbursement practices, and sponsor/developer experience level. A robust loan agreement and collateral documentation are also essential.

A bank's risk rating system should be commensurate with its size and complexity, with transparency, granularity, and independence being key characteristics. A granular rating system can aid management in identifying the exposures that should be reduced or eliminated if a CRE downturn appears to be on the horizon.

To assess the potential losses in a CRE downturn, a bank should conduct stressed loss rate testing. This involves determining loss rates at levels that could be expected during a market downturn and forecasting the ultimate effect of these losses on capital.

A stressed loss rate test can provide useful input to a bank's capital, earnings, and liquidity planning, and inform management of the possible level of the bank's exposure if a CRE downturn were to occur.

Here are the key considerations for a risk rating system:

Credit underwriting standards are the foundation of sound lending policies. They should communicate the level of risk acceptable to the bank's board of directors and provide clear, measurable underwriting standards for lending staff.

An institution's lending policies should consider internal and external factors, such as market position, historical experience, and staff capabilities. This helps evaluate all relevant credit and market factors when making lending decisions.

Independent property inspections are crucial in managing construction loans. Initial site visits and ongoing inspections during the construction phase help ensure the project's progress and identify potential issues.

Loan disbursement practices should be based on engineering or inspection reports, and require lien waivers from subcontractors. This helps prevent potential risks and ensures the loan is disbursed correctly.

An institution's lending policies should establish standards for the sponsor/developer's experience level. They should have a proven track record and sufficient experience in the market and property type to complete the proposed project.

Here are the key items to consider when managing construction loans:

An institution's lending policies should permit only limited exceptions to underwriting standards. When an exception is permitted, it should be documented and approved by management to ensure it's in the best interest of the bank.

Credit Risk Rating is a crucial aspect of credit and risk management. A well-designed risk rating system can help banks accurately assess the risk levels of their commercial real estate (CRE) loans.

Risk rating systems can vary greatly between community and large banks. A small bank may need only a one-dimensional rating system with a small number of rating grades, while a large or complex organization may require a rating system with more grades to measure risk levels adequately.

Transparency is critical for any risk rating system. Account officers, loan review personnel, and regulatory examination staff should be able to review rating guidelines and reach the same conclusion on the rating grade assigned to individual credits. Specific, objective rating criteria rather than broad, subjective criteria promote consistency in the rating process.

A granular rating system that effectively rank orders risk should aid management in identifying the exposures that should be reduced or eliminated if a CRE downturn appears to be on the horizon. This is especially important for banks with CRE concentrations, which possess an additional level of risk and complexity.

Independence in the validation process is the third leg to any successful rating system. Individuals outside the lending process should evaluate and validate the entire process. Banks with limited staffing resources can use external audit staff or consulting firms to conduct the validation.

To ensure the effectiveness of the rating system, credit review personnel should provide the board and senior management with periodic feedback regarding the effectiveness of the rating system and any recommended changes for improving transparency and granularity.

Here is a breakdown of the characteristics of a successful risk rating system:

Stressed loss rates are a crucial aspect of credit and risk management, especially for banks with concentrations in commercial real estate (CRE) loans. Banks need to determine loss rates at levels that could be expected during CRE market downturns and forecast the ultimate effect of these losses on capital.

To develop stressed loss rates, banks should start by obtaining historical loss rates on CRE loans at the most granular level available. This means looking at data from previous market downturns, which may be available from internal data or external sources like the FDIC. The FDIC has historical CRE data that could be used to construct loss rates, although it lacks much granularity.

Banks should identify loss rates that occurred as a result of previous market downturns, which may lag the downturn by a number of months or years. For example, if a bank experienced high loss rates in 2008, they may use those rates to estimate losses in a future downturn.

The usefulness of stressed loss rate testing relies heavily on the reference portfolio selected. Banks with limited or only recent experience in CRE lending may need to use external data, which may or may not be applicable. In these cases, the type and level of adjustments to historical loan loss rates are critical elements to developing a useful outcome.

Banks should adjust the loss rates to account for similarities or differences between their current portfolio and the historical reference portfolio. This may involve using more granular data, such as loss rates for specific product types like suburban hotels versus downtown hotels.

Here's a step-by-step guide to developing stressed loss rates:

Property owners are facing a higher risk of defaults due to the current market conditions. Two property owners have already defaulted this year, with one landlord defaulting on nearly $2 billion in debt for seven office buildings in major cities.

These defaults are not isolated incidents, as Mark Rose, CEO of Avison Young, has stated that he has never seen the level of office givebacks this high. This suggests that the problem is widespread and not limited to a few specific cases.

The risk of defaults is further exacerbated by the fact that some property owners are struggling to negotiate modifications or restructurings of their debt. For example, Brookfield, a Canadian asset manager, has stopped payment on about 2% of its properties while trying to negotiate a modification or restructuring of its debt.

A granular risk rating system can help identify the exposures that should be reduced or eliminated if a CRE downturn appears to be on the horizon. A bank's risk rating system should rank order risk in the portfolio and provide enough grades so that the vast majority of loans do not fall into just one grade.

Here are some key characteristics of a good risk rating system:

Banks with commercial real estate (CRE) concentrations should conduct portfolio stress testing to assess their exposure to a downturn in CRE markets. This type of analysis can help identify specific vulnerabilities and inform management on where to take action to mitigate those risks.

Stress testing can be conducted on a portfolio-wide basis, measuring the depth and breadth of the portfolio's vulnerability to changes in real estate markets and interest rates. This can involve determining market fundamentals for each product type and geographic market where the bank has funds committed.

Systematically aggregating the results of individual transactional stress tests can be done by testing each credit in the portfolio, considering the current status of each project against the impact of sensitivity analysis forecasts. The bank can then aggregate the impact of each tested credit to determine the vulnerability within the portfolio.

Here are some common assumptions to be tested for CRE lending:

Portfolio management and analysis are crucial for banks with concentrations in commercial real estate (CRE) to assess their exposure to a downturn in CRE markets. Stress testing can be used to determine the extent of this exposure and identify vulnerabilities in the portfolio.

Stress testing can be conducted on a portfolio-wide basis, measuring the depth and breadth of the portfolio's vulnerability to changes in real estate markets and interest rates. This analysis can be conducted on a scheduled basis or when market fundamentals dictate.

Transactional sensitivity analysis is a valuable tool for banks originating CRE loans, as it measures the impact of changes in market fundamentals on the loan's performance. This analysis can be conducted on a loan-by-loan basis, testing assumptions such as absorption rates, sales prices, and interest rates.

A range of outcomes may be used to determine if the loan meets the institution's underwriting criteria and lending standards. Systematically aggregating the results of individual transactional stress tests can involve determining market fundamentals for each product type and geographic market, developing sensitivity analysis forecasts, and testing each credit in the portfolio.

Scenario analysis is another technique used by banks to make assumptions about how their CRE portfolio would react to a particular event, such as layoffs at a major employer. This analysis can help identify potential vulnerabilities in the portfolio and inform risk management decisions.

Ratings migration analysis is a technique used by some banks to stress ratings migrations, which can help identify potential downgrades in the portfolio. This analysis involves reviewing prior years' migrations to determine the typical migration experience and selecting a stress year based on economic variables or conservative estimates.

Table 1 shows the types of assumptions to be tested for CRE lending, including properties for sale and lease, loan variables, and contingency reserves.

Table 2 shows the effects of a market downturn on CRE loan ratings, with the average annual migration rate and the stress scenario annual migration rate.

By using these techniques, banks can gain a better understanding of their CRE portfolio's exposure to market downturns and identify potential vulnerabilities, enabling them to make informed risk management decisions.

CBRE is a commercial brokerage firm that's also a major commercial lender. They originated over $40 billion in loans for the 12 months ending in September 2020.

Their commercial loan closings are on the rise, with a 31.6 percent increase from June to September 2021.

Cash flow is a top priority for cash flow lenders, who focus on a borrower's ability to clearly service debt obligations. They use a bottom-up approach to underwriting, starting with net operating income or net income/EBITDA.

Most commercial banks, credit unions, and large financial services firms tend to play in the "A" space, which is characterized by strong cash flow and prime locations. This means they often have access to less expensive capital sources.

Cash flow lenders are often called "A" or "prime" lenders not because they're better at lending, but because their sources of capital tend to be less expensive.

To pursue a career in Portfolio Management and Analysis, you'll want to explore the following learning paths.

The Commercial Real Estate Lender role requires specialized knowledge, which can be gained through a role-based learning path.

Portfolio Management involves analyzing and optimizing investment portfolios, which requires strong analytical skills.

Commercial Real Estate Lenders need to understand financial markets and instruments to make informed decisions.

Learning paths for Portfolio Management and Analysis can be tailored to individual career goals and interests.

Developing expertise in financial modeling and data analysis is essential for a career in Portfolio Management and Analysis.

The commercial real estate market in the United States is a major contributor to domestic GDP, representing $1.2tn in total revenue in 2021.

According to IBISWorld Industry Research estimates, commercial real estate is the largest asset class after stocks and bonds, valued at $8.8tn in 2021.

Here are the top lenders in the commercial real estate market, based on our 2021 ranking:

Commercial mortgage is the most common type of commercial real estate lending, which requires a strong understanding of CRE lending analysis and underwriting from both real estate and financial services professionals.

Meridian Capital Group is a leading commercial real estate lender with a diverse portfolio of financing options. They have originated a mix of financing from coast to coast, including office construction loans in Los Angeles and mixed-use refinancing packages in New Jersey.

In the past five years, Meridian Capital Group has provided $121 billion in multifamily-backed debt alone, as well as $24 billion and $12 billion in the office and retail sectors, respectively. This demonstrates their significant presence in the commercial real estate lending market.

Meridian Capital Group offers a wide range of financing options, including non-recourse mortgages, small balance loans, and HUD/FHA financing. This flexibility allows them to cater to various client needs and preferences.

Meridian Capital Group's focus on multifamily lending is evident in their loan servicing portfolio, which totals $121 billion.

Working with a commercial real estate lender can be a viable option for businesses seeking financing. The advantages of this route include a faster and more lenient application process. Higher interest rates than bank loans are also a benefit.

However, it's worth noting that the interest rates may be higher than those offered by banks. Your interest rate will depend on your loan-to-value ratio, type of business, credit score, and overall financial health and stability.

To secure a commercial real estate loan, you'll typically need to make a 20% to 30% down payment. In addition to this, you'll also need to pay upfront fees such as property appraisal, survey fees, legal costs, and loan origination fees.

Here are some of the upfront fees you can expect to pay:

A commercial loan broker can be a valuable asset in this process, helping you understand the loan and its guidelines, preparing a loan application, and representing your interests throughout the process.